Is it time to buy resource stocks?

By David LennoxFebruary 2016min read

Sector’s battering continues, but turning point will occur in 2016.

The Australian resource sector, and indeed global commodities, were buffeted by major headwinds in 2015 and the ASX 300 Resources Index (capital only) shed 25.2 per cent in value over the calendar year. The rout has continued into early trading of 2016, with the index posting a further loss of 1.1 per cent by mid-January.

The negative return generated by the Australian resource sector over the past 12 months was driven by two major, and well documented, themes that soured investor sentiment toward the sector: China and the rising US dollar.

First, the China story continued to dominate sentiment, with investors concerned the country would face a “hard landing” economically. China is the single biggest consumer of most commodities, hence it is crucial to the resource sector’s well-being.

The negative sentiment was continually reinforced throughout calendar year 2015 as the release of economic data showed China’s economy was continuing to slow. The chart below shows the slowdown in China’s annual growth rate.

Source: Trading Economics

Indeed, China’s key domestic indicator in its gross domestic product (GDP) slowed, with annual growth slipping to 6.9 per cent in 2015 and 6.8 per cent in the December quarter. This compares to annual GDP growth for the December quarter 2014 of 7.2 per cent.

China’s economy also faced a slowing global economy and also a decline in domestic activities, especially infrastructure development. But the reduction in infrastructure investment is part of China’s economy moving away from being investment led and more towards consumer based.

The slowing GDP also led authorities to initiate a number of stimulatory measures in 2015. These included devaluing the yuan, lowering official cash rates and restructuring taxes on consumer items. All were designed to stimulate domestic activity, to first stabilise and then turn GDP growth around.

The second factor weighing on the resource sector was the rise in the value of the US dollar, which has put downward pressure on US-dollar-denominated commodity prices.

The US dollar increased in value as investors, during 2015, waited for the US Federal Reserve to initiate the first increase in US cash rates for 10 years; rates were lifted on December 16 by a quarter of one per cent. Market expectations are that the Fed will continue to lift the cash rate over 2016 and hence the US dollar has continued to rise and commodity prices have fallen. That is bad for resource stocks.

What to expect in 2016

We believe 2016 could finally mark an inflection point for Australian resources and more broadly global resources. Although the charts have yet to confirm this, there are a number of reasons why a bottom in the resource sector could be close at hand.

Looking at China first, we believe its authorities will continue in early 2016 to apply stimulatory measures to the economy, and that they will start to have a positive impact on the Chinese economy in the latter part of this year and certainly in 2017.

The headwinds from a rising US dollar on commodity prices will also, we believe, die away. The Fed will be very constrained in its ability to raise cash rates, given deflationary risks, US dollar strength, and the fact that other key trading partners are engineering their currencies lower. This should provide some respite for US-dollar commodity prices.

Also helping the sector will be the fact that commodity supply responses by the industry should start to ratchet up. (Editor’s note: lower commodity prices encourage producers to reduce supply or cut back on future investment, which in turn helps driver higher commodity prices as there is less supply overall to meet demand.)

Resource oversupply is a concern, with oil a prime example as OPEC has kept the taps open and oil has flowed. However, prices (oil has dropped below US$30 a barrel) now mean that a large part of the world’s supply of many commodities is becoming uneconomic for higher-cost producers.

High-cost oil production has already been shut in and investment deferred. We expect this to be an increasing trend across the commodity spectrum, and this will actually see prices spike up as demand recovers.
(Editor's note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a financial adviser before acting on themes in this article.)

Gold starts to shine

Ironically, the prospect of higher future inflation is already evident in one commodity, gold, which has held up well and is actually up a few per cent this year at around $1100 an ounce.

We see gold as being the ultimate insurance against further debasement of currencies, and expect the gold market to have a big year. We favour Evolution Mining, which has been building production scale and is also getting a tailwind from a rising gold price in Australian dollar terms.

Despite the pessimism now encompassing the resource sector, we believe the latter part of 2016 will be a key inflection period. Therefore, in the trading environment we envisage for this year, it is important that investors, when looking to invest in the sector, identify, among others, three key metrics:

the quality and life of the mining company’s assets,

positioning on the cost curve (is it a high or low-cost producer),

the structure of its balance sheet (is it financially sound).

The quality and life of the assets provides a company with options in development timing and speed of completion, and can deliver lower project capital costs. Furthermore, such an asset base can generate low operating costs, and it is important where such costs fall along the commodity cost curve for individual mines.

A company with operations that are clustered toward the low end of the commodity cost curve (a lower-cost producer) can deliver margins, albeit smaller, during commodity price volatility; now being experienced by the sector.

The final metric is the structure of the balance sheet, which should comprise a sustainable debt amount. Debt levels should be such that when asset values are tested by rigorous impairment writedowns, there is no peril in debt rising as a portion and endangering the company.

High-quality assets can support greater sustainable debt levels, as valuation movements should be less punishing. Moreover, low debt will generate low interest expense and also conserve cash flow.

Conclusion

Based on our expectation that 2016, especially the latter part, will be an inflection point for the resource sector, current market weakness may offer entry opportunities. Furthermore, our belief in China as a major player in the reversal of fortunes in the resource sector would favour a focus on gaining exposure to commodities going into that country.

Specifically, iron ore and copper exposure may now offer excellent entry value as 2016 unfolds. More broadly, the energy sector may now also provide investment opportunities, in view of the sector’s capitulation.

In the near-term, resources could remain under pressure, but armed with our 2016 outlook we will be closely monitoring blue-chip Australian resource companies, including BHP Billiton, Oil Search and Evolution Mining as ideal candidates to leverage into a 2016 resource-sector recovery.

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This article appeared in the February 2016 ASX Investor Update
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